Sunday, 4 September 2011

Balancing base and variable pay - Banking Vs other industries

Variable pay is broadly
intended as a cash supplement paid in one or more lump sums by an employer to
its employees, in addition to base pay, to recognise their superior, sustained contribution
to the achievement of the organizational aim and objectives, that is to say to
the pursuance of its strategy.

Variable pay, which
in contrast to base pay “needs to be re-earned” to be repeated, is habitually part
of more complex reward packages, which are introduced and developed by
employers according to a specific reward philosophy to induce their employees to
perform at the required standard and exhibit the desired behaviour.

The question is whether this approach to reward
management has been invariably used by employers in all of the existing industries
and sectors and, more in particular, whether it has been traditionally adopted
by the financial sector organizations. It can be maintained that to both
questions the answer is: arguably no.

From the reward
point of view we have basically witnessed two different approaches with the
passage of time: one adopted by the financial sector institutions and the other
one essentially embraced by all of the other industries.

Over the years and
across the world, banks and financial institutions have not habitually showed
to be particularly concerned with the design and development of sophisticated
and craftily devised total reward models, cafeteria-benefits schemes or other
similar programmes. On the other hand, traders and bank executives have hardly ever
been expected to be offered by their employer neither the opportunity to choose
amongst a variety of possible benefits which to pick nor prospects for career, development,
involvement and growth. This particular type of professionals has invariably been
interested only in one kind of reward, to wit: financial reward and more
specifically bonuses.

It could be argued
that this conclusion is wrong in that traders are actually interested in both
basic pay and bonuses, but this really seems not to be the case according to what
has been, relatively recently, claimed by a former senior HR Professional at an
investment bank in London, who recounted that the bank he was working for employed
individuals receiving bonuses worth £5 million on a quarterly basis, whereas their
basic salary was of £100K/£150K a year. In one occasion, by reason of a problem
occurred with the bank’s payroll system, some of them did not actually receive
their pay for six consecutive months, but none of them did even realize that. In
fact, it was the HR department which later found it out and informed the individuals
concerned (Smedley, 2011).

Whether we consider that traders are actually
used to earn bonuses which are much higher than their base salary, this
circumstance should not actually come as a surprise. During a hearing with the
Treasury Selected Committee, for instance, a UBS Executive told that the bank
was used to reward senior investment bankers with bonuses whose value was between
five and ten times their basic pay. UBS did not really represent an exception in
that this practice was absolutely in line with the industry standard.

Reward professionals
working in other industries may wonder about the appropriateness of the financial
institutions reward strategies and philosophies. These should be indeed designed
and developed to enable organizations to attain their overall business strategy,
encourage a specific behaviour and foster the company core values and beliefs.
How could hence such type of reward strategy be developed and executed by HR?

Clearly based on
bonuses, this type of reward strategy was indeed sorely consistent with banks
strategy and values, and encouraging the behaviour these actually intended to
foster and endorse.

The anonymous
former senior HR professional mentioned above claimed that the individuals in
the bank he was working for were assessed according to the immediate profits
these were able to generate. The organization’s culture was clearly essentially
and exclusively inspired by reward, or to be precise by financial reward
(Smedley, 2011). Traders were encouraged to attain just one aim: make as much
money as they could insofar as overlooking the risks associated with their
delicate activity. The case of French trader Jérôme Kerviel, former employee of
Société Générale, represents just one of the most glaring examples of that.

The system was, to put it mildly, really murky. Traders
were encouraged to make the most money they could, receiving a lot of cash when
they were successful. After all, even though banks were paying large sums of
money in bonuses these were calculated and paid as a percentage of what traders
had brought to their institution. It was not a problem hence for banks paying
such huge bonuses; at least as long as the system was flowing without any major
inconvenience.

The flip side of
the system was that, for uncanny it might appear to be, in the event traders
were not bringing in money for the bank and were rather losing it noting would have
happened. The sooner traders were making money for the bank, the sooner they would
have had their bonuses paid; in case of good performance they received very
large sums of money, otherwise it would have occurred nothing.

Since the riskier a
financial transaction is, the larger the profit it can potentially generate,
traders were encouraged to take more than their fair share of risk in order to
make staggering profits. All of that rigorously in the short run in order not
only to earn a lot of money, but also to do it quickly. Once again, former Société
Générale trader Jérôme Kerviel is a striking example of what a single person could
be able to do, but also an amazing example of how true is that at superior level
nobody was able to comprehend the transactions traders were performing on the
bank behalf; never mind to assess the risk, which was never subject to appropriate
control.

As suggested by the
Independent Commission on Banking, reported profits on the basis of which
traders were paid were clearly neither risk- nor time-adjusted. The reference
to the inappropriateness of the timing refers here to the emerged lack of
consistency between the overall bonus system mechanism and the banks long-term
interest. The system was essentially designed to “encourage excessive-risk
taking” (Stiglitz, 2011) or even gambling.

Could have HR and
reward specialists helped to avoid the impending disaster caused by excessive
bonus payment? Either we consider bonuses as a contributory factor to the global
financial crisis or, as claimed by Cotton, as a “symptom rather than a cause”, we
could agree with Williams (2011) which it is very likely that HR could have done
little or nothing to avert the disaster. Trying to persuade banks boards to
change their bonus payment system could have been tantamount to pure madness.
When in 2008 RBS (now state run) changed its bonus system, shifting from cash
bonus to fully deferred bonus, it experienced a brain drain phenomenon causing attrition
to double and attaining after an 18-month period the average rate of
approximately 16 percent.

Smedley (2011) suggests that the real point was
that nobody was considering the risk associated with “high-value reward for
short-term risk-taking”, the problem was hence caused by the way the system was
operated and banks used to generate profit.

Wright (2011) contends
that the major risk was not associated with the payment of bonuses for
transactions made in the short run, but rather with the circumstance that
bonuses were paid before the final outcome of the transaction was known.
Deferred bonuses actually existed already, but banks did not have recourse to
this bonus payment method in that they would have otherwise immediately lost their
talents. What it would actually happen whether Real Madrid, Arsenal or Inter
Milan should propose their soccer players a £200K salary a year? Lured by the
staggering pay offered by Barcelona, Chelsea and Milan, players would
immediately change employer and thus team.

The anonymous
former senior HR professional claims that as long as traders were enabling the
bank to collect large sums of money, these could do whatever they wanted.
Nobody, for instance, dared to dismiss a manager, who had received several
final written warnings on his personal record, as this alone accounted for the
10 percent of the bank profit.

After the financial
crisis burst, the way banks and financial institutions were paying bonuses to bankers
publicly emerged and once everybody was acquainted with the issue, as
expectable, regulators come to play.

In the UK, the
Companies Act 2006 included already specific rules concerning the disclosure of
the reward packages received by the banks and financial institutions boardrooms
members, but bankers and senior executives’ pay was not included in the
provisions. The UK Financial Services Authority Remuneration Code and the
European Capital Requirement Directive III (CRD III) were subsequently promulgated
and some significant restraints introduced. More in particular, the FSA Remuneration
Code introduced some rules prescribing that:

- No less than half
the amount of the agreed bonuses should be paid by employers in the organization’s
shares or in other equivalent non-cash means;

- At least 40
percent of the incentives paid to “code staff”, that is to say senior managers,
risk takers, staff in charge of control functions and other staff receiving a
remuneration package at senior management level, had to be paid over a period
of at least three years;

- For the individuals
whom receive an annual pay higher than £500K this ratio (40 percent) of
variable pay or incentives had to be raised to 60 percent;

- Firms could no
longer offer guaranteed or retention bonuses of more than a year.

The EU CRD III
directive went indeed further afield ruling that, in their annual report, organizations
need to provide:

- Information about
the way remunerations are decided and reward systems developed;

- Explanation of the
link established between pay and performance;

- Elucidation of
the reasons and underlying principles for the employer deciding to have recourse
to variable pay;

- Thorough details
of the senior managers and risk-takers remuneration.

In order to avert the risk typically associated
with traders’ activity, banks are now reinforcing their risk control systems
and developing some KPIs enabling them to assess individual performance in a
systematic way, taking account of risk exposure. Whether proposed by the HR
function, such measures would have been tantamount to HR bureaucracy and would have
been definitely rejected by the banks boards (Williams, 2011).

Despite it would
have been virtually impossible to do it in the past, by reason of the way the
overall system was operated, banks are now turning towards more traditional performance
management processes and developing engagement strategies (Wright, 2011). Reward
specialists are hence clearly gaining a major role within banks and financial
institutions. Their role, notwithstanding, is everything but straightforward,
they have to design, develop and implement practices capable to attract and
retain individuals who are used to earn large amounts of money, and even
quickly, no more exclusively relying on financial rewards (albeit it is likely
that cash will firmly remain amongst the most appealing components of the banks
total reward packages).

The EU blueprint
for the CRD IV Directive, drafted with the stated intent of preventing the risk
of other international financial crisis, stresses the need to introduce rules setting
a bonus-to-salary ratio. The recent Greek’s crisis and the dangerous knock-on effects
it may produce upon other European countries are likely to be part of the
reasons behind this plan. The FSA and the other European institutions concerned
could then be shortly prompted to establish mandatory rules concerned with the
bonus to base pay ratio.

As claimed by Gosling (2011), whether the
European Commission is back to the topic is because the conundrum is far from
having being definitely addressed. Gosling (2011) claims that whether a rule
imposing a bonus-to-salary ratio should be debated it will cause a “vigorous
discussion” about how prescriptive it should be. There has already been a
certain degree of concern in the UK for the way the FSA may amend the Remuneration
Code currently in place in that the FSA is habitually imposing more stringent
and cogent regulations compared to its European counterparts. The circumstance
that the largest number of European banks is in London and that, as claimed by
some commentators, the FSA could hence set the standard is not enough. Whatever
the case, the new rules can produce the desired effects only and only whether at
least all the European banks will have a common, shared regulation or different
regulations substantially similar. As Nava (2011) pointed out, European
countries need to have all the same rules and this objective can be attained only
by means of a common regulation. Differently, it is very likely that there will
be a considerable number of traders’ relocations across Europe. International
extra-EU mobility invariably remains a viable option, but perhaps slightly less
likely to be taken into consideration by many traders.

The CRD IV, drafted
in a bid to make more unlikely or less significant the eventual governments
intervention in case of other financial crises, is aimed at introducing regulations
prescribing banks stricter capital requirements and better liquidity
management, basically imposing banks and financial institutions to keep part of
their equity capital and set a ratio of equity to risk weighted assets. The
meaning of these rules is clearly that to force banks and financial
institutions to keep on board some parachutes. The problem is that banks have essentially
to pay for these parachutes, with the immediate consequence that these will
have less cash to invest available to them. In order for banks to continue to
be productive or not reduce the productivity levels to which these are used, these
should attain better ROI rates. All of that, nonetheless, as aptly suggested by
Wright (2011), could have the effect to increase the “temptation” to favour
short-term risk investments.

To attract new and
retain current talents banks could opt to increase the fixed component of their
financial value proposition. Increasing traders’ base salaries,
notwithstanding, would clearly impact the institutions fixed costs, which will
make it in turn harder for organizations to eventually face future downturn
periods. This move in fact entails that in case of a recession, in order for
banks to reduce costs these will have no other option but to make employees
redundant.

Balancing overall
pay towards variable pay does not potentially pose the same threat; banks can
also pay individuals large sums of money, but only when and whether the business
performs well.

The question is whether rules and regulations can
be actually capable to definitely address the problem of their own. According
to the former City senior HR professional, traders will always strive for cash
and very generous bonuses. These will hence constantly seek the best, that is
to say more rewarding, opportunities and are unlikely to stay any longer in a
bank whether there is another bank offering more generous bonuses. Traders
currently do not stay with the same bank for more than 3/4 years so that
changing employer for this type of professionals is considered somewhat of normal
already.

According to Cotton
(2011), regulations can have a limited effect in that these are invariably retrospectively
drafted, in other words they tend to settle problems which have already
occurred, but are unlikely to prevent the impact which unexpected new circumstances
can produce. The new regulation may thus prove to be ineffective to prevent the
future occurrences caused by different reasons.

In terms of reward
and of how employers balance the ratio between fixed and variable pay, it can be
averred that, once again, we will witness two completely different scenarios. Whilst
the aftermath of the financial crisis seems to prompt banks to redress their
views about the composition of their reward packages, or rather, of the ratio
of fixed to variable pay, the other industries are recently doing and planning
to do exactly the opposite move. In general, private sector employers, contrary
to banks, are the more and more incline to contain base salary and to offer
more generous variable components of financial reward to their staff according
to their actual results. Used in such a way, bonuses could actually be
considered fairer than they might apparently seem to be. This is also the
conclusion emerged from the findings of a relatively recent investigation
carried out by Farmer (2010). The study, which covers the period from 2003 to
2007, when the new regulation imposing big companies to disclose their top management
remunerations had been introduced, includes the salaries of 200 UK’s big organizations
such as Tesco, British Airlines, GSK, BT and WHSmith.

The findings of
this investigation revealed that only 38 percent of CEO’s bonuses were received
automatically, that is, without any correlation with their organizations’ actual
performance. In the remaining 62 percent of the investigated cases, the CEOs
received higher financial reward packages if, and only if, they had done a good
job enabling the business to increase its profits or share price. By contrast,
in case of the organization negative performance, CEOs underwent a salary
reduction (Tobin, 2010).

Farmer’s
investigation showed that when examining financial reward it is particularly
important to consider its different components separately, rather than the
overall compensation package. Whereas long-term share incentives aim at
rewarding individual success, for instance, basic pay is not clearly habitually
offered to attain the same objective (Tobin, 2010). The study also revealed
that the reward packages of private sector executives are designed more
properly than those of traders and senior bank executives. During the period
from 2003 to 2007 these salaries have in fact increasingly aimed at rewarding
long-term achievements, rather than short-term success.

Over the period investigated,
the proportion of variable reward linked to long-term incentives increased from
22 percent to 28 percent. Yet, CEOs aiming at receiving higher levels of
variable pay had to show their shareholders that they really deserved it by achieving
better results than their industry competitors (Tobin, 2010).

Farmer could not
extend his investigation to banks for a whole range of reasons; amongst these,
as claimed by Farmer himself, the circumstance that a thorough and reliable
investigation would have required access to senior bankers pay in addition to
that of boards members. The Author also stressed the circumstance that at the
moment of the study bankers bonuses were “used synonymously" with
executive pay. Additionally, as discussed earlier, many bankers habitually earn
much more than banks executives (Tobin, 2010).

Farmer acknowledged
that the way bonuses are managed within banks is typical of the banking and
financial industry only and that the same approach is not used by the employers
of the other industries.

An example of an exception
to the rule that CEOs earn their reward packages according to their real
contribution to their organization’s success is definitely represented by the
Australian BlueScope Steel case. Despite the business concluded the year 2010
posting a more than considerable $1 million loss and 1,000 jobs went lost, the
steelmaker’s CEO was granted a staggering $721,000 bonus (Jacob, 2011).

The national secretary of the Australian Workers
Union, Paul Howes, sharply criticised the move and Nick Xenophon, Australian Independent
Senator, defined the event as a “dark day for corporate governance” and as
“something particularly obscene” considering that the organization had to cut 1,000
jobs. The BlueScope Steel’s spokesperson later revealed that in the fiscal year
2011 executives’ bonuses were reduced by more than 10 percent (Jacob, 2011). This
represents hence the exception which proves the rule; the organization in fact
promptly reviewed its executives’ bonus system.